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Chapter 1
Overview of a Financial Plan
n Chapter Overview
Every individual and family needs to develop a financial plan to make the best use of resources to achieve financial goals. Financial planning will help them clarify their goals and ensure that spending, financing, and investing decisions are aligned with those goals.
Chapter 1 discusses the benefits of financial planning: making your own financial planning decisions, judging the advice of financial advisers, even becoming a financial adviser. In addition, this chapter briefly discusses the six component plans that makeup the overall financial plan. These components are budgeting and tax planning, managing liquidity, planning and financing large purchases protecting wealth and income through various types of insurance plans, investing money, and retirement and estate planning. Different life events quite often necessitate a change in the financial plan and goals.
Each of these component plans requires six steps. First, an individual must establish financial goals.
Once these are established, the individual must consider his or her current financial position. Next, alternative plans that could help achieve the goals should be identified and evaluated. At this point, one plan should be chosen and implemented. In the final two steps, the individual evaluates his or her financial plan and revises it as needed.
n Chapter Objectives
The objectives of this chapter are to:
· Explain how you benefit from personal finance.
· Identify the key components of a financial plan
· Outline the steps involved in developing your financial plan
n Teaching Tips
1. Discuss this quote with students: “Most people don’t plan to fail; they fail to plan.” Ask students
for examples of situations (financial or otherwise) where they have seen this happen. Guide the discussion toward financial matters.
2. Relate financial planning to planning a trip.
Steps in Financial Planning / Steps in Planning a TripSet goals / Decide where you are going
Determine your current financial position / Locate your home on the map
Identify and evaluate alternative plans / Identify and evaluate alternate routes
Choose and implement a plan / Pick a route and start journey
Evaluate plan / Is the trip going smoothly?
Revise plan as needed / Road construction causes major delays,
so you pick an alternate route
A financial plan is just a financial road map.
3. Many younger students have difficulty recognizing the benefits of devising a financial plan now and saving for the future at a young age. The compounding of money can be easily demonstrated using the “Rule of 72.” The Rule of 72 can be used an indicator of how long it will take a single sum of money to double in value at a given interest rate or rate of return percentage. The length of time is calculated by dividing 72 by the interest rate. For instance, at 8% a sum of money would double every nine years. Provide this example for students:
What if your parents had been able to invest $1,000 at 8% the day you were born?
Age / Value of Investment / Age / Value of Investment0 / $ 1,000 / 45 / $ 32,000
9 / 2,000 / 54 / 64,000
18 / 4,000 / 63 / 128,000
27 / 8,000 / 72 / 256,000
36 / 16,000 / 81 / 312,000
This concept also can be used further to determine the rate of return necessary to achieve a financial goal by simply dividing 72 by the number of periods available to reach the financial goal. This answer will provide the percentage return needed to reach that goal. For instance, a $10,000 down payment on a house is desired in nine years. Currently, $5,000 is the amount saved. The needed return would be 8%. Other considerations, such as amount of risk to be taken, would then also need to be assessed, but this is a quick tool to make preliminary estimates.
4. Have students develop a written set of goals. Suggest a minimum of two goals for each time frame—short-, intermediate-, and long-term goals. One of the short-term goals should be achievable by the completion of the course. Remind students that goals need not only to be written but should include a definitive dollar amount, should be monitored, and should be assessed periodically to determine progress toward overall life goals.
5. Teams—at the beginning of the semester/class, divide students into teams of three to five students. In many chapters, these teams can be used to discuss concepts and issues and to review quantitative materials and quizzes.
6. Discuss with students that goals are not stagnant. They change as an individual’s life changes. The addition of a spouse or child or changing careers or jobs, for example, often mean reviewing and perhaps modifying financial goals. Changes in the economic environment can affect the achievement of financial goals positively or negatively. The last decade, unfortunately, had negative effects on most consumers’ financial goals, including delaying the purchase of a house, retiring, or changing careers, etc. Encourage students to share their family experiences relative to loss of jobs, foreclosures, postponing or eliminating education plans, etc.
7. A good team exercise to introduce the members to each other and to generate discussion is to distribute a “financial goals/interests” questionnaire. Each member of the group gives an answer, which is recorded on the questionnaire. This discussion readily shows how different people are relative to their finances, and how important it is to know each other’s financial goals in a relationship.
Sample questions:
How much will you need annually to live comfortably in retirement?
How much do you need for an annual clothes budget?
What percentage of your income do you intend to save?
What type of vacation do you envision on an annual basis?
Will you support your children through college?
What is an amount needed for a nice dinner at a restaurant?
Do you believe in using credit cards for long-term purchases, or do you believe you should pay the balance in full each month?
Do you need a new car or are you content with used cars?
8. Survey the class by a show of hands: Which job would you accept?
Job #1—35 hours per week with a beginning salary of $75,000. It is everything you do NOT like to do. You get four weeks of vacation.
Job #2—60–70 hours per week with a beginning salary of $25,000. It is everything you ever dreamed of doing in a career, but you receive only one week of vacation.
After a show of hands, ask several students why they chose either job? This usually generates animated discussion of different value systems.
9. Online courses—individual or team submissions on questionnaires, review sheets, and Internet exercises can be helpful.
10. Search the Web for “CNN Money 101.” There are 23 personal finance lessons to learn various personal finance topics. Each lesson has a quiz to be taken. There is instant feedback and scores, which can be submitted or just used for discussion.
n Answers to End-of-Chapter Review Questions
1. Personal financial planning is the process of planning your spending, financing, and investing in order to optimize your financial situation. A personal financial plan involves decisions about financial goals and describes the spending, financing, and investing plans necessary to achieve those goals.
2. An opportunity cost is what you forgo as the result of a decision. Some of the opportunity costs of spending $10 on lottery tickets might be not eating out for lunch once a week, reducing debt by an additional $40 per month, or having $520 in savings at the end of the year.
3. An understanding of personal finance enables you to make more informed decisions about your financial situation. You would be able to better judge the advice of financial advisers. You might even pursue a career as a financial adviser.
4. (1) Budgeting and tax planning
(2) Managing your liquidity
(3) Financing your large purchases
(4) Protecting your assets and income (insurance)
(5) Investing your money
(6) Planning your retirement and estate
5. Budget planning represents the process of forecasting future expenses and savings. It involves evaluating your current financial position by assessing your income, your expenses, your assets, andyour liabilities.
6. Your net worth is your assets (what your own) minus your liabilities (what you owe). You can measure your wealth by your net worth and budgeting strategies can help you increase your net worth and thereby your wealth. For example, you can build your net worth by setting aside part of your income to invest in additional assets or reduce your liabilities.
7. Income is influenced by education and career decisions. If expenses are not accurately estimated, it may be difficult to reach savings goals. Many financial decisions are affected by tax laws, such as certain types of income being taxed at a higher rate than others. Knowledge of tax laws allows you to make more favorable choices.
8. Liquidity means having sufficient funds to cover short-term cash deficiencies. In managing your liquidity, you consider money management and credit management. Money management means deciding how much money to retain in liquid form and how much to invest. Credit management deals with the decisions you make on the amount of credit to use to support your spending.
9. Factors to consider in managing financing include: the size of the loan you can afford to borrow, the length of time for the loan, and selecting a loan that charges a competitively low interest rate.
10. The primary objective of investing is to use funds not needed for liquidity purposes to earn a high return. Most investments also carry an amount of risk. Potential investments include stocks, bonds, mutual funds, and real estate.
11. A plan to protect your assets requires insurance planning, retirement planning, and estate planning. Insurance planning involves determining the types of insurance you need such as health, automobile, and life. Insurance reimburses you for damages to your assets, limits your exposure to potential liabilities, or protects your income. Retirement planning involves determining how much money you should set aside each year for retirement. Retirement planning must begin well before you retire so that you can accumulate sufficient money to invest and use after you retire. Estate planning is the act of planning how your estate will be distributed after you die. Effective estate planning can protect your wealth against unnecessary taxes and ensure that your wealth is distributed to your family in the manner that you desire.
12. Budgeting focuses on the relationship between your income (cash inflows) and spending (cash outflows). Liquidity management focuses on depositing excess cash or obtaining credit if you are short on cash. Financing focuses on obtaining cash to support large purchases. Protecting your assets focuses on using some of your cash to purchase varying types of insurance. Investing focuses on using some of your cash to build wealth. Planning your retirement and estate dictates the wealth that you will accumulate by the time you retire and its distribution before or after your death.
13. (1) Establish your financial goals
(2) Consider your current financial condition
(3) Identify and evaluate alternative plans that could achieve your goals
(4) Select and implement the best plan for achieving your goals
(5) Evaluate your financial plan
(6) Revise your financial plan
14. Your goals will influence the amount of money and the timing you need to achieve the goals. If goals are not realistic, they will be very difficult to accomplish, and you will become discouraged and lose an interest in planning. Short-term goals are those to be accomplished in less than a year such as saving $500 for Christmas gifts. An intermediate goal takes from one to five years to accomplish, such as paying off a three-year note. A long-term goal takes more than five years to accomplish;
an example is saving for retirement in a set number of years.
15. Some factors that might affect your current financial position are: your level of debt, your marital status and family responsibility, your age and level of wealth accumulated, your career choice, and your level of education.
16. Your goals are where you want to be and your current financial position is where you are. Your alternative financial plans will “map” how to get from one position to the other. Several alternative financial plans are possible given one’s current financial position and goals. For example, two alternative plans may involve different amounts of savings.
17. Once you have developed and implemented a plan, you must monitor it. Monitoring the plan will ensure that you are following the plan and that the plan is working as intended.
18. You may find you need to revise the plan to make it more realistic. In addition, your life circumstances and financial condition may change. As your financial conditions change, your goals may change, especially as the result of specific events such as graduating college, getting married,
or the birth of a child.
19. · Bank deposit rates: buy now versus save decision
· Prices of homes and cars in your area: planning for purchase
· Financing rates on car loans, personal loans, and home loans: deciding how much of a loan you can afford
· Stock price quotations and quotations on other investments: deciding when to invest and where to invest